Variance Risk Premium and Investment Uncertainty

50 Pages Posted: 13 Jul 2016

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Babak Lotfaliei

Finance Department, San Diego State University

Date Written: July 1, 2016

Abstract

This article documents that variance risk premium decreases investments by the firms. The premium increases the value of waiting to invest in the real-option framework; risky volatility adds to the hedge value of postponing non-recoverable project costs. Empirically, we also find a negative relation between the variance risk premium and the firms' investment. In particular, the relation is more important for investment-grade firms with low historical volatility and high volatility risk premium. In a preliminary analysis, we report a puzzling conservative investment behavior by the investment-grade firms, which only can be addressed by considering the premium.

Keywords: Real option, Variance risk premium, Optimal timing, Stochastic volatility

JEL Classification: D81, G13, G31

Suggested Citation

Ericsson, Jan and Lotfaliei, Babak, Variance Risk Premium and Investment Uncertainty (July 1, 2016). Available at SSRN: https://ssrn.com/abstract=2808765 or http://dx.doi.org/10.2139/ssrn.2808765

Jan Ericsson

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Babak Lotfaliei (Contact Author)

Finance Department, San Diego State University ( email )

5500 Campanile Drive
San Diego, CA 92182-8236
United States
+16195944790 (Phone)

HOME PAGE: http://cbaweb.sdsu.edu/faculty/profile/Babak-Lotfaliei

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